To add to what pparks already told you, XP Mode is fully working Windows XP SP3 stored on a virtual hard disk (vhd) file. It installs as a Windows Virtual PC virtual machine, and is accessed from the host system using Remote Desktop Services.
XP Mode uses its own emulated hardware and drivers, for instance AMI System BIOS, S3 Trio GPU and SounBlaster 16 sound. It is capable to run most of the XP compatible software, making it ideal solution to run older legacy applications. However, because of the (emulated) hardware limitations you might find out that especially some graphics intensive applications, mostly games, do not work as well as you'd expect.
XP Mode can also redirect USB devices making it possible to use older devices like scanners and printers not compatible with the host OS (Windows 7).